What change in China (or otherwise) means for your portfolios

Xi 3.0?

Xi Jinping seems to have strengthened his grip on power after the most recent Communist Party Congress. This should give him a better chance of pushing through his vision of Party-controlled reform.

While such a model may not generate the best long-term potential growth, it should still help mitigate debt risk, contain deflationary pressure and support consumption over the medium term. Slower growth is a sacrifice the leadership seems willing to make. But what does this mean for investors?

An alphabet soup of indices

There are many ways of investing in China today. In fact, with so many options available, the choice can be baffling. Indices can have almost identical names, but offer vastly differing exposures and very different returns. How then do we decipher this alphabet soup of indices offering “broad, diversified exposure to China equities”? In our view, it’s best to look at the ingredients.

How China indices have performed

No longer as simple as A or H

China is now the world’s second largest equity market by capitalisation. That growth has come with greater awareness of the nuances of the A- and H-share markets, and the fact that there’s long been a premium associated with investing in the former. That premium endures, but it has become much less volatile, and much less marked, in recent years as the connectivity between the two markets has increased.

A-shares will finally start being added to the MSCI Emerging Market index from June 2018. This integration will be limited initially and gradual, as more needs to be done on corporate governance, suspensions, trading limits, transparency. Yet this is a positive signal, and it should have an impact on confidence and capital inflows.

That said, we still believe it’s more important to look beyond questions of A and H right now and dig deeper into the nature of the companies your choice of index exposes you to. ​

Know your ingredients

There has been a big rally YTD in China, but the various indices have performed very differently. For once though, the driver is not onshore/offshore but the scale of the exposure to the traditional state-owned enterprises (SOE) or the new tech giants. The effects of this two-speed economy are plain to see in the chart below. Valuations in some of the more consumer-led areas – including tech – are now looking very stretched indeed.

Open sesame​

Tencent and Alibaba ADR – which together represent around 75% of China’s tech sector and around 30-40% of indices like the MSCI China – have delivered stellar returns of 80%+ and 100%+ respectively so far this year.

For those share prices to keep rising as they are, we need to see a continuation of the phenomenal earnings growth of the last ten years, but this looks unlikely. c. 50x Forward P/E doesn’t look sustainable to us. Earnings growth is much more at risk in the new economy as markets mature and competition rises

As privately owned firms, the tech titans won’t benefit from Xi’s vision of the role of the Party and the State in the economy. They may in fact be held back as they are called on to become strategic investors in businesses in which they’d never normally invest. That said, we’re not calling the end of the tech boom, merely advocating a better portfolio blend of old and new

Don’t look back in anger​

Many of the stalwart SOEs of days gone by are now under new, more progressive management and starting to enjoy the fruits of reforms on mixed ownership and reducing capacity. In our view, making them more productive and freeing up resources from inefficient SOEs is the most critical reform for long-term growth

The three main components of the reforms – mixed-ownership, mergers and capacity reduction – are all expected to speed up from here. Whether they will truly make SOEs more efficient over the longer term is unclear, but they will increase the capital they have at their disposal, and boost market shares and pricing power in the short term. That will support some indices more than others. You may need to look back to move forward.

Where you find SOEs​

SOE share in the industrial sector (in terms of assets, 2015)

Source: NBS, SG Cross Asset Research/Economics

SOE share in the services sector (in terms of assets, 2013*)

​

* 2015 data are used for retail sales, wholesale and catering services sectors. Conservative estimates made for financial services, accommodation, and real estate sectors, due to lack of data. The asset size of financial services is CNY162tn in 2013, a number too high to show in this chart.Source: NBS, SG Cross Asset Research/Economics

Old, but gold

So which indices allow you to play the old economy theme? Broadly speaking, the indices fall into two main camps – financials tend to form the major part of H-share indices while it’s the consumer-related sectors (where the presence of SOEs is least felt) and industrials that lead for A-shares. If tech valuations concern you, the HSCEI Index may be a good bet. As the table below shows, it avoids the sector completely.

Index

Exposure

Shareclasses

No of stocks

Consumer Discretionary

Consumer Staples

Energy

Financials

Healthcare

Industrials

IT

Materials

Real Estate

Telecoms

Utilities

MSCI China

Offshore

H,B, Red chips, P chips, ADRs

150

10.1

2

4.8

22.4

2

4.6

40.3

1.3

4.9

5.3

2.3

Hang Seng China Enterprise

Offshore

H

40

3.8

0

10.6

72.6

1.4

5.3

0

1.3

1.2

1.8

2.1

CSI 300

Onshore

A

300

11.7

7

-

34.8

4.6

14.4

9.1

7.5

5.2

-

2.7

MSCI China A

Onshore

A

581

12.5

7

-

23.5

6.6

16.7

10.3

11.8

5.7

-

3

MSCI China A International

Onshore

A

369

11.2

8.3

2.5

26.7

6.2

16.8

8.8

9.7

5.3

0.8

3.6

Source: Bloomberg, MSCI . 3 November 2017

One other thing to note, China has proven a particularly tough nut for active managers to crack in recent months, with just 12% of managers outperforming in Q3. Over 10 years, only 37% have beaten the benchmark*.

*Source: Morningstar and Bloomberg data from 30/09/2007 to 30/09/2017.

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